Bubbles, Malinvestment, and Higher Education

Artificially low interest rates wreak havoc again.

Many commentators are asking whether the next big bubble to burst will be the debt associated with the rising cost of higher education. College costs have strongly outpaced the inflation rate, and the debt students are racking up is crippling. So what is driving this process and what consequences does it have for students? I have some thoughts below, informed by Austrian economics.

Rather than a bubble, it’s probably more accurate to call it a “mini-boom” of an Austrian variety. One factor fueling the rising cost of higher ed–and it’s not the only one–is government provision of student loans at artificially low interest rates; this encourages borrowing, especially for the long term. As a result, too many people spend too much time in college, and more people attend college than should. One can think of this as malinvestment in human capital caused by distorted interest-rate signals.

Another way to look at this is that the low rates lead people to invest in the general human capital (knowledge and skills) associated with higher education rather than the more specific human capital that comes from workforce experience and on-the-job training. No matter how much of a “knowledge economy” we have, we still need cars repaired, septic systems fixed, and meals cooked at restaurants.

Thus just as inflation induces people to invest too much in longer term production processes at the expense of consumer goods, so subsidizing of college induces people to invest too much in the longer term production process and higher order human capital associated with higher education. This distorted structure of human capital is ultimately not sustainable if it doesn’t match the pattern of skills demanded in the market. When graduates can’t find jobs that enable them to pay off their debts, boom will go bust. It is, as we say of inflation-generated booms, unsustainable.

Driving Up the Price

The other complicating factor here is that, like in inflationary booms, subsidizing an activity drives up its price. Just as inflation leads borrowers to bid up the prices of the inputs needed in the early stages of long-term production processes (think of the rising cost of materials during the housing boom), so does artificially cheap borrowing for higher education enable students to spend more on college than they would otherwise. That increased demand pushes up tuitions. With more students able to afford college, schools have upped the ante by providing more and better amenities to attract them, which requires higher tuition and fees to cover those costs. Government mandates have also added to the administrative bloat at many institutions, further raising costs and tuition.

Forgiving student loans seems a tempting option for dealing with the boom. Like homeowners during the housing boom, students with a lot of debt have been victimized, both by the artificially low interest rates and the constant drumbeat of “everyone has to go to college.” The problem with forgiving this debt is that it creates serious moral-hazard problems–if the federal government wipes out this debt, why should anyone believe that future debt won’t be treated the same way? Whatever is true of the current borrowers, good policy should be made based on long-term institutional incentives not (just) short-term considerations.

The Way Out

The real way out of the higher education bubble is twofold. First, stop subsidizing the demand side through artificially low rates of interest on government loans. We need to find out how much both young people and potential employers really value the human capital acquired through higher education. That will only happen with market-driven loans and interest rates.

Second, we need to unleash real competition on the supply side by ending the government mandates and opening up higher education to new institutions, curricula, and pedagogies. There’s a place for a good old-fashioned liberal arts education, but it is not for everyone. Greater competition will drive down costs and give students choices that better match what they think they need. Getting government out is the only sure way to stop the boom before the coming bust gets any worse.

THE FREEMAN

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December 2014

Unfortunately, educating people about phenomena that are counterintuitive, not-so-easy to remember, and suggest our individual lack of human control (for starters) can seem like an uphill battle in the war of ideas. So we sally forth into a kind of wilderness, an economic fairyland. We are myth busters in a world where people crave myths more than reality. Why do they so readily embrace untruth? Primarily because the immediate costs of doing so are so low and the psychic benefits are so high.